Cloud Computing and the Credit for Increasing Research Activities

Cloud computing has created
significant changes in information technology and
continues to influence various industries and
sectors including in the fields of education and
government, and for technology companies
themselves. Significant investment has been made
at the national level. The United States has
created a federal cloud strategy with the
objective of reducing operational costs via
economies of scale across multiple federal
agencies. The goal, as laid out by the federal
government, is to reduce annual federal
information technology (IT) spending from $80
billion to $20 billion (see Kundra, Federal Cloud
Computing Strategy (CreateSpace
Independent Publishing Platform 2011)).

This item’s focus is on the tax implications
for users, providers, and developers of the cloud
outside the realm of the government: specifically,
how a taxpayer’s rental expenses for cloud
computing for purposes of research and development
(R&D) of new products and solutions should be
treated under the Sec. 41 research tax credit
(RTC).

What Is the Cloud?

The “cloud” is a method of outsourcing IT
functionality to a virtual environment that allows
increased flexibility and scalability in response
to supply and demand. The opportunities are
endless, and the cloud can significantly shorten
the software development life cycle by delivering
products efficiently to customers on a global
scale.

Cloud service providers (CSPs) are
facilitating this revolution. CSPs offer a
multitenancy model, thereby creating a secure
setting with performance metrics of equal caliber
to traditional hosting or dedicated on-premise
solutions. There is an increasing trend of
software development companies leasing space from
the CSPs. This practice creates efficiencies for
software development companies by allowing the
leasing of storage space necessary for development
and testing. Without such an option, the expenses
related to on-site hosting of the equipment
essential to developing applications is often
insurmountable or cost-prohibitive to many
taxpayers. In this model, the software developer
can test a solution in a live setting, which
offers the ability to assess the feasibility and
scalability of a solution in a more cost-effective
manner.

The growth of the cloud is
accelerating. With such rapid development comes
significant uncertainty in many facets of the
model. For example, the typical ideas of
ownership, licensing, purchasing, and
administrative issues have been fundamentally
altered when compared to historical models of
providing software solutions to customers.

Are Cloud-Computing Server Rental
Expenses Eligible for the RTC?

To qualify
for the RTC under Sec. 41, eligible R&D
expenses must be either in-house expenses or
contract research expenses. This item
evaluates each class and subclass of potential
qualified research expenses as they relate to
cloud-computing server rental expenses. First, the
discussion analyzes the three most common
qualified expense class types (wages, supplies,
and contract research) as to their appropriateness
for classification of these particular costs.
After that analysis, the fourth expense class
type—rental or lease costs of computers—is
examined and determined to be an appropriate
classification.

Qualified research (1) must
be undertaken for the purpose of discovering
information that is technological in nature and
the application of which must be intended to be
useful in the development of a new or improved
business component of the taxpayer; (2)
substantially all of the research activities must
constitute a process of experimentation; and (3)
the experimentation must relate to a permitted
purpose.

Wages: Rental expenses for
cloud-computing servers and equipment are not
“wages” as defined in Sec. 41(b)(2)(A)(i) and
Regs. Secs. 1.41-2(c) and (d). These expenses are
not compensation payments subject to withholding
or any of the other elements of wages under Sec.
3401(a). Nor are the expenses related to qualified
services under Sec. 41(b)(2)(B).

Supplies:The term
“supplies” is broadly defined to include any
tangible property, other than land (and
improvements to land) and depreciable property,
that is used in the conduct of qualified research
under Sec. 41(b)(2)(C). The lease expenses related
to the fees charged by the CSPs for the use of
their hardware do not fit within this
definition.

Contract research:For an
expense to qualify as a contract research expense,
the expense must either be an “amount paid or
incurred by the taxpayer to any person (other than
an employee of the taxpayer) for qualified
research” or an expense related to payments to
another person for the performance on behalf of
the taxpayer for services that would constitute
qualified services within the meaning of Sec.
41(b)(2)(B) and Regs. Sec. 1.41-2(c).

Under
Sec. 41(b)(3)(A), 65% of “any amount paid or
incurred by the taxpayer to any person (other than
an employee of the taxpayer) for qualified
research” is eligible for the RTC. For the CSP
rental expenses to qualify as contract research
expenses, the CSP services must constitute
qualified research. In and of itself, standard CSP
service does not constitute research; the CSP
rental service fees only provide the taxpayer with
the means to conduct its own qualified research.
The expenses for CSP rentals do not rise to the
level of “qualified services” under Sec.
41(b)(2)(B) and thus would not qualify as contract
research expenses.

Rental or lease costs of computers:When a taxpayer meets the
requirements for qualified activities under Sec.
41(d)(1), the associated CSP server rental
expenses appear to fit most favorably within the
classification of rental or lease costs of
computers under Sec. 41(b)(2)(A)(iii), which
provides that “any amount paid or incurred to
another person for the right to use computers in
the conduct of qualified research” may qualify for
the RTC.

Access to cloud-computing servers
through CSPs is merely the modern equivalent of
computer leasing that was undertaken in the 1980s
and early 1990s. At that time, the cost of
computers with substantial data and storage
capabilities was prohibitive for all but the
largest companies and universities. This expense
had the potential to drastically inhibit R&D
related to software solutions. Computers of this
magnitude and power were necessary to reduce the
solutions’ time to market as well as the
investment by the taxpayer. The owners of these
computers were able to provide access to several
lessees (allowing them to use a multitenancy
platform to reduce their costs to the end
lessees).

Though the technology may have
improved and evolved over time, the concept is the
same today as in prior decades. Modern technology
leveraged by CSPs falls within the requirements of
Regs. Sec. 1.41-2(b)(4), which requires that (1)
the computer be owned and operated by someone
other than the taxpayer; (2) the computer be
located off the taxpayer’s premises; and (3) the
taxpayer not be the computer’s primary user. When
a taxpayer rents from a CSP, the servers are owned
and operated by a party other than the taxpayer,
the servers are located off the taxpayer’s
premises, and the taxpayer is not the primary user
of the servers.

What This
Means to the Taxpayer

Having established a
foundation to properly classify expenses paid to
CSPs, it is important to highlight the practical
concerns of properly identifying those expenses
for both taxpayers and tax practitioners. By the
nature of the expense, software companies are apt
to have payments to CSPs, especially those with
less-developed IT infrastructures. Within the past
few years, companies with little or no previous
involvement in software development have expanded
their investment in web applications and mobile
development, often choosing to host applications
externally. Even companies with established IT
infrastructure have migrated their applications to
CSPs, especially when issues of scalability for
users and data are present (two areas that often
require R&D to solve technical challenges). At
the conclusion of development, the company may
continue to lease for hosting purposes. Those
expenses would not be qualified under any
classification of expense for the RTC.

The
necessary analysis must determine the qualified
development efforts that meet the RTC’s criteria.
When evaluating the potential qualified research
activities for companies in these situations, it
is essential to query the software development
managers and review the associated contracts
regarding the nature of the payments to the
CSPs.

It is important to clarify that these
expenses are not for simple file storage, mail
hosting, and other similar activities. Further, it
is important to delineate what portion of the
payments are for hosting software under
development versus payments for hosting a stable
software release. If the company is undertaking
qualified research activities under Sec. 41(d)(1),
the associated expenses related to the lease of
server space from CSPs to facilitate the software
development should be classified as rental or
lease costs of computers for RTC purposes.

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

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